A low rate of inflation stimulates economic growth. Rise in price level initially leads to increase in profit ratio, investment, output, employment level and income. However, hyper inflation results in fall in the value of money and decline in purchasing power.
Inflation reduces saving and capital formation. It also discourages the entrepreneurs from taking risk involved bin the production. It adversely affects the quality of production. Resources are diverted from the production of essential goods to earn profit.
Inflation discourages the inflow of foreign capital because foreign investment becomes less profitable due to rising cost of production.
The adverse effects of inflation on production are discussed below:
(1) Misallocation of Resources:
Inflation causes misallocation of resources when producers divert resources from the production of essential to non-essential goods from which they expect higher profits.
(2) Changes in the System of Transactions:
Inflation leads to changes in transactions pattern of producers. They hold a smaller stock of real money holdings against unexpected contingencies than before. They devote more time and attention to converting money into inventories or other financial or real assets. It means that time and energy are diverted from the production of goods and services and some resources are used wastefully.
(3) Reduction in Production:
Inflation adversely affects the volume of production because the expectation of rising prices along-with rising costs of inputs bring uncertainty. This reduces production.
(4) Fall in Quality:
Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.
(5) Hoarding and Black marketing:
To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then the producers sell their products in the black market which increases inflationary pressures.
(6) Reduction in Saving:
When prices rise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.
(7) Hinders Foreign Capital:
Inflation hinders the inflow of foreign capital because the rising costs of materials and other inputs make foreign investment less profitable.
(8) Encourages Speculation:
Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits. Instead of engaging themselves in productive activities, they speculate in various types of raw materials required in production.